“Don’t Fight The FED”

 

“DON’T FIGHT THE FED” has certainly been the battle cry that has dominated the investment landscape over the magnificent run-up, not only in equities, but a revived housing market.  Indeed, gains like these have not been seen in years and have been a welcomed reprieve for many who held through the violent ride of the past 15 years.  Intuitively, it feels as though there must be a substantial tab for the insatiable expansion of the Federal Reserve’s balance sheet.  But what exactly is the cost of our gluttony?

The charts above are certainly rudimentary examples of our economy and oversimplified.  However, their implications are profound.  Particularly when you consider that our monetary supply is more than double what it was before the credit crisis.  Assuming a relatively low production of goods (relative to the pace of monetary expansion) or in the case of land which they’re not making any more of, the implications are startling as seen below.

The flows of money are not always as simple as the above diagrams, invariably as with all things, the path of least resistance is usually the most likely.  Although less clear, this has serious implications as well.  The Fed’s policy mandate explicitly states that “…to increase production so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”  Sadly, this is an oxymoron of monumental proportions.

There’s a reason the production and employment section is BOLD, this is the part of the mandate that has been the sole focus of the Bernanke led Fed.  Armed with a printing press and limited control of interest rates they have put their only tools to use the best they can.   Long-term interest rates currently hover at historical lows, while the US monetary base as previously mentioned has  been expanded at an exponential rate.

Naturally, production cannot possibly keep up with the expansion of capital.  This has a two-pronged effect:

  1. Further increases in capital (QE) have less and less impact on productivity.
  2. Because production cannot keep up with monetary base increases, the capital flows to the path of least resistance;  Liquid, Leveraged, Market Speculation.

Money will inevitably flow into the only places it can find yield, not production and innovation, because these take years to foster, but liquid assets of all shapes and sizes.  Ever wonder why Stocks are at record highs despite unemployment at unusually high levels?

Again, the implications of this are many.  Most noteworthy is that inflation, somewhere, sometime will become a reality, this is a mathematical fact.  It is clearly present in the equity market, educational costs etc.  Currently, the largest risk seems to be in the fixed income and savings markets that do not partake in the benefits of the Federal Reserve’s policies.

We believe there are a few steps that can at least offer some protection to the implications both clear and unforeseen, due to not only Fed, but Central Bank policies around the world.

  • Avoid fixed income particularly long-term bonds
  • DO NOT FIGHT THE FED
  • Have exposure to physical assets in addition to equities
  • Maintain a nimble portfolio, as volatility will likely increase as will risk with the expansion of monetary supplies.  Have an exit strategy for all long-term investments.

The last bullet is of particular emphasis for DCM and we think it should be for your portfolio too.  The market can throw you curveballs.   Just ask hedge fund manager John Paulson who has as much as 85% of his own investment in his funds tied to the price of Gold which just saw the largest two-day price spill on record.  In our opinion, it is imperative that one’s investment plan be nimble enough to not only avoid sharp corrections, but possibly profit from them.

Although we share Paulson’s belief in inflation inevitably flowing into the market, we do not share his blind buy and hold philosophy.  All investors, Paulson, etc. are fallible and that’s why Diversified Capital Management turns to trend capturing models.  Indeed we were well positioned for the monumental break, as price is king, and the short to intermediate trends on gold have been pointing down.

Using this fact, our intermediate and short-term models were able to capture much of the move lower, not just in Gold, but a variety of Commodities.  Sticking to our consistently conservative leverage levels our models rewarded us with a very nice start to April.  That said, it has not been all sunshine and rainbows.  For much of February and March we battled the unusually choppy and volatile commodities, while also using our credit spread trades to stand in front of an incessant rally in the stock market.

In fact, after a period of 4 months without a losing credit spread, we suffered our worst losses to date for the method.  This was the result of the Dow Jones putting together a rally of consecutive positive closes unmatched in almost 20 years.  Even more unusual was the lack of long-term trends found in many commodities.

In response to this activity, we increased our allocation of short-term trading models in the second half of March, which resulted in the best run-up to date for the fund as seen in the weekly returns chart below.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS

Clearly our abundance of trading models and timeframes are working in concert as they are designed.  When one or more are struggling, the others pick up the slack.  This is precisely, why we do not “Marry “a single investment.  Whereas Paulsons’ Funds are invariably linked to the long-term performance of Gold, we believe we are well positioned regardless of where Gold heads.

Best Regards,

 

Duane Cronin

President

 

4/15/2013